THE TRUTH ABOUT APPLE'S STOCK

So, what's the truth about Apple stock at $400 a share?

Is it absurdly cheap, as some Apple stock fans argue--an opportunity to buy the future of the tech and media business at a a 10X forward P/E multiple?

Or is Apple's stock actually overvalued, because, as some Apple bears argue, the company's best days behind it?

The answer is that, at $400, Apple stock seems to be fairly valued.

In other words, the stock seems to be reasonably priced--at a level that takes into account both the potential upside and the potential downside.

The upside story for Apple is as follows:

The company continues to grow at extraordinary rates for a company this size--30%+ per year.
The company maintains share in the smartphone market and doesn't get marginalized into a niche platform by the Android juggernaut
The company's new products for 2012--the iPad 3, the iPhone 5, and the iTV--are blockbuster hits, driving enormous sales growth for several years and opening up a whole new product line (TVs)
The company's Mac business continues to take share from the PC business
Apple is able to maintain its amazing profit margins despite ever more intense competition and sales to more price-conscious consumers (the mass market).

If all that happens, Apple stock could easily get to $1,000 a year in a few years.

The downside story for Apple, meanwhile, is as follows:

The iPhone continues to lose its competitive edge to Android-based phones
iOS gets marginalized--a premium "niche" platform--and ultimately becomes a less valuable platform for developers
iPad sales and profitability get walloped by a new wave of cheaper tablets, from the likes of Amazon.com (which is giving the hardware away at cost to sell more media)
The iTV is a disappointment
Macs fail to continue to penetrate the enterprise
The company loses focus and intensity in the post-Steve era

If all that happens, Apple's stock could get cut in half from here, or worse.

Let's look at the numbers:

In the past three years, Apple's free cash flow has grown at an absolutely astounding rate for a company this large:

APPLE FREE CASH FLOW (Cash from operations LESS capital expenditures)

FY 2009: $9 billion
FY 2010: $19 billion
FY 2011: $33 billion

With the stock at $400, after backing out $83 billion of cash, Apple is trading at about 8X-9X trailing free cash flow. This is a perfectly reasonable multiple for a company with this growth trajectory.

In fact, if Apple's growth rate were very likely to be sustained over the next couple of years, the stock could reasonably trade at a much higher multiple, even 15X-20X. Given Apple's already tremendous size, however, as well as increasing competition, the market is reasonably concluding that the company is unlikely to maintain this growth rate.

If Apple's growth hit a wall, meanwhile, there would be plenty of downside to this free-cash flow multiple.

Dell, a hardware competitor that is not growing, generates about $5 billion of free cash flow per year. Excluding Dell's cash, the company's stock trades at about 3X this free-cash-flow. So 3X trailing free cash flow is probably a good "floor" multiple if Apple's growth were to hit a wall.

If Apple's stock traded at 3X last year's cash flow ($33 billion), the company's enterprise value ex cash would be about $100 billion. Add Apple's $83 billion of cash to that, and you'd have a market value of about $180 billion, or about $200 per share.

If Apple's stock traded at 15X last year's cash flow, meanwhile, the company's enterprise value ex cash would be about $495 billion. Add the $83 billion of cash to that, and you'd have a market value of about $575 billion, or $600 a share.

In other words, at $400, Apple's stock would appear to have about 50% downside and 50% upside, depending on what you think the company's growth rate will be over the next couple of years.

Now, of course, Apple could completely face-plant over the next few years, in which case the downside would be worse than $200 a share. And, of course, the company's growth could continue to soar, in which case the upside would be far greater than $600. So don't think of this as a capped range of outcomes.

The most likely scenario, meanwhile, seems to be that Apple will continue to grow at a very healthy but declining rate, perhaps seeing some margin pressure from competitors at the same time.

If that is what happens, then Apple stock should rise nicely as its cash flow grows, without seeing an explosive pop to the upside or collapse to the downside.

And that's why Apple's stock seems to be fairly valued--not cheap, not expensive--at $400 a share.

(If anything, given how well-positioned it is for the products of the future--smartphones and tablets--it seems to be a bit undervalued.)